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VMWare's Cloudy Virtual Reality

The virtualization specialist trips up on competition and execution.

Investor frenzy for virtualization was enough to thrust VMware(NYSE:VMW) shares some 76% higher on their first day of trading last year. Parent EMC(NYSE:EMC) basked in the glow of its offspring's success.

Today brings us a different story. Both Oracle(NASDAQ:ORCL) and Microsoft(NASDAQ:MSFT) have introduced virtualization software that's cheaper -- and, some might say, better -- than VMWare's. The company's stock has fallen by some 55% this year.

The market researchers at Gartner say that 90% of the servers running virtualization software still use VMware. But that's not as great as it sounds, because only 1% of the server market falls into that category. What's more, it appears that VMWare is being used mostly at large corporations. The market is still ripe for growth, and midsize and small companies have barely been tapped, but with the current economic conditions and tight credit markets, installations have perhaps stalled a bit. That should change soon enough, but will VMWare be there to remain competitive?

There was a lot of hand-wringing over VMWare not too long ago, when a glitch left its software users unable to access their information for nearly a whole day until the company was able to fix the problem. Of greater concern is the potential brain drain that may happen with founder Diane Greene getting the boot. Management is so worried, in fact, that it has offered to reprice post-IPO stock options that are currently underwater, no doubt as an incentive to keep key employees in place.

Repricing stock options is wonderful for the employees, but current shareholders aren't as lucky. Mostly, insiders benefit from repricing, and as I pointed out last month when Aladdin Knowledge Systems(NASDAQ:ALDN) decided to beckon the options-repricing genie, repriced stock options get special accounting treatment under SEC rules: Earnings take a hit every year the stock price moves up until the options are exercised, forfeited, or canceled. The greater the rise in price, the greater the hit to earnings.

In another instance of giving shareholders the shaft, VMWare filed a notice with the SEC after the markets closed on Friday -- usually a good time to release things discreetly, particularly on a long holiday weekend -- that it's paying Greene to go away. Since her employment agreement lacked a provision for a midyear or pro rata payouts, the company agreed to pay $400,000 for her voluntary departure. In return, she will most likely settle all claims with the company.

Unfortunately, rewriting employment contracts after an executive leaves, much like repricing stock options, is an all too common practice that simply transfers wealth from the shareholders to the executive. Most likely, Greene won't need the $400,000 payout anyway, because she owns a large amount of stock options. As long as these options are in the money, she is likely to benefit immensely.

Partisans might object to their stock being tagged as richly valued, yet even at its much reduced price, it's still exceedingly the case. The stock trades at 32 times next year's earnings, about three times Microsoft's and IBM's (NYSE:IBM)forward price-to-earnings ratios. Its expected growth rate might suggest that it can handle such a lofty valuation -- it's more than twice Oracle's long-term growth rate and four times that of Sun Microsystems(NASDAQ:JAVA) -- but third-quarter sales guidance of between $462 million and $468 million were well below analyst forecasts.

VMWare investors might remember when triple-digit share prices were more than a virtual reality. But now, greater competition isn't just a pie-in-the-sky fantasy.

Fool contributorRich Dupreyowns shares of Aladdin Knowledge Systems but has no financial position in any of the other stocks mentioned in this article. You can see hisholdings. The Motley Fool has adisclosure policy.

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Rich has been a Fool since 1998 and writing for the site since 2004. After 20 years of patrolling the mean streets of suburbia, he hung up his badge and gun to take up a pen full time.

Having made the streets safe for Truth, Justice and Krispy Kreme donuts, he now patrols the markets looking for companies he can lock up as long-term holdings in a portfolio. So follow me on Facebook and Twitter for the most important industry news in retail and consumer products and other great stories.